Four Themes to Shape Institutional Portfolios

Institutional investors often define investment objectives as a numerical risk/return target and their portfolios reflect this simplified view. This approach, however, could result in asset allocations, benchmarks and investment strategies that are not in sync with investors’ desired outcomes.

“Institutional investors should consider a broad range of issues when developing the overall strategy for their investment portfolios,” said Andrew C. Smith, chief investment officer, Client Solutions Group at Northern Trust. These may include financial, fiduciary, business, and social objectives as they all play a role in ensuring the outcome matches the purpose for investing, he added.

“By organizing their objectives and reconciling short-term and long-term goals, investors can become aware of action-oriented themes that can help them shape and prioritize decisions,” Smith said. “These themes help align objectives, asset allocation, benchmarks and product selection, all crucial factors to ensure the investment purpose is achieved.”

To that end, Northern Trust has identified four key themes that are expected to influence institutional investment portfolios now and for the foreseeable future:

• Managing Volatility
• Investing With Purpose
• Managing New Aspects of Risk
• Finding Yield in a Low-Rate Environment

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Managing Volatility

"Investment outcomes are negatively impacted by excess volatility. Northern Trust's outlook is that heightened event risk will persist throughout 2012," Smith said. "This should come as no surprise, given the uncertainty created by sweeping regulatory changes within the financial industry, socio-political instability in the Middle East, the European Union and Russia, upcoming elections and leadership changes within G20 nations and ongoing contagion risk from the debt crisis in Greece."

In many cases investors are not aware of all their options for addressing volatility.

1. Alternative Strategies. At an asset class level, investors can integrate alternative strategies – like hedge funds and private equity – into traditional asset classes in an effort to reduce equity correlation and to provide downside protection.

2. Dynamic Allocation. At the asset allocation level, investors can reduce volatility by being more nimble, employing Global Tactical Asset Allocation (GTAA) to proactively change the portfolio’s risk profile by altering market exposures or by adding go-anywhere strategies like global macro or managed futures into an opportunistic bucket.

3. Volatility Reduction Strategies. At the product implementation level, investors can reduce volatility by implementing high-dividend, high-quality, low-volatility strategies or using risk-weighted indexing strategies

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Investing With Purpose

Increasingly, institutional investors are acknowledging broader mission objectives beyond simply maximizing wealth or minimizing risk. Northern Trust refers to this trend “investing with purpose.” Incorporating fiduciary, social and business objectives are each examples of this trend.

"I truly believe purpose-based investing will grow in importance as institutional investors acknowledge a broader definition of objectives," Smith said.

Key trends to watch for under this theme include:

1. Defined Benefit Plans. In an effort to reconcile fiduciary and business risks, DB plan sponsors are adopting glidepaths to gradually rebalance corporate and fiduciary objectives over time.

2. Defined Contribution Plans. DC plan sponsors are shaping their plans to reflect their unique employee, industry and sponsor framework by tailoring plan design, features and communication.

3. Public Pensions. Public pension plans are focusing on closing the funding gap and reducing funding volatility by reconciling their objectives of upside participation and downside protection through strategies such as GTAA, hedge funds and low-volatility portfolios.

4. Foundations and Endowments. Foundations and endowments are continuing to expand their adoption of environmental, social and governance (ESG) and socially responsible investing (SRI) objectives, while emphasizing, inflation protection, yield enhancement and volatility reduction.

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Managing New Aspects of Risk

Smith also noted how the definition of risk continues to expand. In recent years institutional investors have become more aware not only of the various aspects of risk, but also the importance of managing it effectively.

"It is easy to become overwhelmed by the risks investors face today," Smith said. "But, if the events of the last three to four years have taught us anything, it is that unmanaged risks are the investors' downfall. We need to manage risk, not just report on it."

Among the types of risk investors must manage are:

• Market
• Liquidity
• Regulatory
• Inflation
• Fiduciary
• Tail
• Credit

Unfortunately, many investors do not possess the time, internal tools and expertise necessary for proactive risk management. As a result, there is a trend toward partial outsourcing to leverage suppliers and third-party providers to build more efficient risk management solutions.

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Finding Yield in a Low-Interest Rate Environment

Income-seeking institutional investors face a challenging global financial environment as they look to replace the traditional yield-generating components of their investment portfolios. Low growth, low inflation and an ongoing demand/supply imbalance for high-quality bonds have all kept downward pressure on yields. Given recent statements by the European Central Bank and the U.S. Federal Reserve Board, this situation is expected to persist through 2012 and 2013.

"Against this backdrop, institutional investors will need to consider new sources of yield – including new investment strategies and even new asset classes – in order to replace yield from traditional sources," Smith said.

There are a number of ways to enhance yield in an investment portfolio depending on an investor’s priorities and objectives. For example:

1. Duration and Risk Priorities. An ultra-short duration fund might meet the objectives of a segment of the portfolio currently invested in cash. In addition, there may be unexplored opportunities to enhance yield by moving up the duration curve to longer-term bonds or moving down the credit scale to incorporate high-yield bonds or emerging markets debt.

2. Unconventional Yield Sources. Less conventional sources of yield can be added to the investment portfolio. Quality dividend paying stocks, higher yielding index funds – and even certain hedge fund strategies – are all potential non-traditional sources for enhanced yield.

By organizing their actions around key themes, institutional investors are focusing on their investment purpose, identifying things they can control and enhancing their chances of achieving success by better aligning portfolio objectives with asset allocations, benchmarks, and investment strategies.

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